How are Credit Scores Calculated? Your credit score is a number assigned to you by the credit reporting agencies to predict how likely you are to pay your bills on time.
Here’s how it works. The reporting bureaus look at certain elements of your credit and bill-paying history to determine where you are in a credit score range that measures all consumers who have ever applied for a credit card, loan, mortgage, or any other form of credit. The scale generally ranges from 300 to 850, depending on which of the three credit reporting agencies is determining your credit.
For TransUnion, the range is 300 to 850, while for Equifax, the range is 280 to 850. Experian uses two credit score scales, one ranking scores on a scale of 360 to 840 and the other from 330 to 830. The Fico generic credit score, which is used by many banks in evaluating your credit application, uses a 300 to 850 range.
Here are the principal factors that go into calculating your credit score, including an approximation of the percentage weight given to each factor by the credit reporting agencies:
Bill Payment History: 35%
The largest component of the credit score calculation is your bill paying history. Your credit report summarizes your financial profile and lists any credit cards, mortgages, car loans, student loans, and other loans in your credit history. Any late payments or delinquencies will show up on your credit report, together with the number of days the payment was late (for example, 30, 60, 90 days, etc.). Even one late payment will result in a lower credit score, and will appear on your credit report for up to seven years. Experts estimate that you need at least two years of perfect bill payments over multiple accounts to counter the negative effects of even one late bill payment.
The best way to improve your credit score is to pay your bills on time. Setting up an online bill pay schedule that automatically makes a payment at a designated time each month is a great way to ensure that you are never late with your payments. For those accounts that don’t allow for automatic payments, you can schedule an email or calendar reminder ten days before the due date to make sure that you mail out your payments on time. Google calendar provides a reoccurring reminder that is easy to set up and free.
If you are ever late on a bill payment, you should contact the lender at the customer service help line and request that they excuse your late payment. Lenders will often excuse a late payment for borrowers with an otherwise good payment history or for extenuating circumstances. You should also ask the customer service representative whether the late payment will be reported to any of the credit reporting agencies.
Debt-to-Credit Ratio: 30%
The credit score considers the amount of outstanding debt as a percentage of the total credit available to you, otherwise known as your “credit utilization rate.” You want to keep this rate as low as possible.
You can improve your debt-to-credit ratio by paying off your debts. Lowering your debt, such as by paying off your credit cards or, to the extent possible within your own economic means, making extra payments on your car loan, mortgage or other extension of credit, will improve your credit utilization ratio by decreasing the calculation’s numerator.
You can also improve your debt-to-credit ratio by increasing the amount of your available credit — the denominator in the debt-to-credit ratio. Opening a new credit card may actually help your credit utilization rate, provided that you do not make any large purchases with that new charge card and pay off any purchases promptly. While the incurrence of new debt may drop your credit score by a few points, the new credit availability will have a long-term positive effect on your credit score. However, it is important to keep in mind that multiple credit card applications will hurt your credit score, so you should apply for new credit or charge cards infrequently and only when necessary.
Additionally, you should maintain old credit card accounts, even if you rarely use those credit cards. Keeping those old accounts in place will increase the amount of credit available to you – the denominator in your credit utilization ratio. Closing those unused credit card accounts may actually lower your credit score by increasing your debt-to-credit ratio.
Length of Credit History: 15%
Another factor in determining your credit scores is the age of your credit history. The credit bureaus will look at when you established your credit profile — that is, when you first borrowed money on credit — together with the type of credit account you opened and the degree of activity on that account.
For this reason, many personal finance experts recommend that parents encourage their children to open a credit card at an early age, provided, of course, that the children have reached the requisite level of maturity and understand the importance of responsibility in managing their financial affairs.
Additionally, if at all possible and consistent with your personal financial situation, you should try to use your older credit cards from time to time, so that otherwise dormant accounts show some activity on your credit report. Occasional use of your older, otherwise inactive, credit cards will have a positive effect on your credit scores.
New Credit Inquiries: 10%
Your credit score will factor in the number of recent credit score inquiries you may have made, such as recent credit card applications. The thought is that multiple applications for credit may indicate a particular need for funds, which might suggest an increased credit risk for lenders.
Accordingly, you should avoid applying for multiple credit cards or otherwise submitting credit applications over a short period of time. An example of when multiple credit card application may occur is during the holiday season, when consumers are bombarded with various offers to apply for merchant-branded credit cards in return for 10% off or other savings on initial card purchases. Applying for those credit cards may provide a welcome discount on holiday shopping purchases, but it will also lower your credit score.
Consumers in the market for a new home or car, or who are looking to refinance an existing mortgage, should avoid applying for a credit card during the month preceding an application for a mortgage, car loan or refinancing. The multiple credit applications over a short period of time may potentially decrease your credit score at the time you apply for the mortgage or car loan.
Types of credit: 10%
Your credit score assess the types of credit in your financial profile, and awards a higher score for a more varied credit history. For example, a diverse credit history with cards allowing you to pay your balance over time (such as a MasterCard, Visa or Discover card), a charge card requiring you to pay the balance at one time (such as an American Express card), a mortgage, and a car loan will generally receive a higher score than a credit report with only one type of credit.
So, where do you rank in the various factors that make up your credit score? By reviewing your credit report and determining how you rank in the individual elements that go into calculating credit scores, you can address those areas where you can take immediate action to improve your credit score.
For more personal finance advice including helpful tips on how to improve your credit score, go to CreditScoreFree.net.
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